23 November 2011

Mody/Sandri: The interplay of sovereign spreads and banks' fragility in the eurozone

This column argues that the payoffs from strengthening banks' balance sheets can still be large and, therefore, fiscal support is merited. But a more resolute strategy for winding down banks is also needed.

European policymakers are confronting a heightened crisis characterised by a perverse and seemingly intractable interplay between sovereign debt pressures and financial sector fragilities (Wolff 2011). Three questions arise:

1. How did the crisis reach this stage?
2. How should we think of policy options when the financial sector and sovereign weaknesses threaten to pull each other down?
3. What policy interventions have the best chance to succeed at this time?

To shed light on these questions, Mody and Sandri analyse the correlation structure between weekly changes in sovereign spreads and banks’ equity valuations in a panel of eurozone countries.

Policy implications

Financial markets fostered the very imbalances that they are so ferociously punishing now. The resulting destabilisation has had grave consequences. Some may argue that the destabilisation was inherent in the design of the eurozone. That may well be the judgement of history, but clearly the markets have greatly amplified it. As plans are wrought for the future of the eurozone, much thought is being rightly given to fiscal integration and fiscal transfers. But it would be a mistake to forget that a weak banking system can have far-reaching costs, which no amount of fiscal rectitude can eventually handle.

A lesson of Mody/Sandri's paper is that banking fragilities are not primarily to be sought in their cross-border dimensions but even the domestic negative feedback loops from banks to sovereigns and back can be potent. As such, a robust banking sector will be central to a more stable eurozone.

Policy options are now much more constrained. Investors are questioning the fiscal sustainability of several countries and this is creating additional pressure on those banks that are directly exposed to sovereign bonds. Clearly the ability of such countries to support their financial sectors is compromised. A more precise policy approach is needed. It is important to keep in mind that the payoffs from strengthening banks’ balance-sheet can still be large and, therefore, fiscal support is merited. But a more resolute strategy for winding down banks is also needed.

Where banking models have failed or proven fragile, a credible approach to phasing down such banking operations is needed. At the start of the crisis, bank resolution powers were relatively limited in most European economies. A lesson learned from the crisis is the need for such powers, which now are more widespread. In this regard, time is of the essence, as the crisis has once again demonstrated that delays can be extremely costly. Prompt action may still have the potential to turn around the current vicious cycle between sovereign downgrades and banks’ losses.

Full article

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